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The Federal Reserve Bank of Dallas is out with its 2011 annual report Thursday, and it should come as little surprise that the district overseen by inflation hawk Richard Fisher is making something of a splash.

“If you are running one of the “too-big-to-fail” (TBTF) banks—alternatively known as “systemically important financial institutions,” or SIFIs—I doubt you are going to like what you read in this annual report essay written by Harvey Rosenblum,” Fisher writes in his letter prefacing the report.

That is because the essay from Rosenblum, head of research at the Dallas Fed, a 40-year central bank veteran and former president of the National Association for Business Economics, takes aim squarely at the “too big to fail” (TBTF) firms, and why the ultimate solution, albeit a difficult one, is to break up America’s largest financial firms.

The TBTF term “disguised the fact that commercial banks holding roughly one-third of the assets in the banking system did essentially fail, surviving only with extraordinary government assistance.” That assistance included: shotgun weddings of failing or failed firms like Bear Stearns, Merrill Lynch, Washington Mutual, and Wachovia to the likes of JPMorgan Chase, Bank of America and Wells Fargo; massive capital infusions under the Troubled Asset Relief Program; and the bailout of AIG that allowed the insurer to pay out obligations to counterparties.

While the rescue effort, no small feat by the Treasury Department and Federal Reserve, kept most of the country’s major financial institutions in business, it saved them from failure on a technicality. “[M]ake no mistake about it,” Rosenblum writes, “A bailout is a failure, just with a different label.”

The financial regulatory reform under Dodd-Frank has been positioned by proponents as the solution, but it does not meet Rosenblum’s standard. “Words on paper only go so far,” he writes. “What matters more is whether bankers and their creditors actually believe Dodd-Frank puts the government out of the financial bailout business.”

While the legislation imposes some market discipline and erodes some of the advantages enjoyed by the biggest banks, it also “lays out conditions for sidestepping the law’s proscriptions on aiding financial institutions.” Most troubling to Rosenblum is the politicized nature of bailout decisions, which will lie with the Treasury, and by extension the president, rather than the Fed. “It may be hard for many Americans to imagine political leaders sticking to their anti-TBTF guns, especially if they face a too-many-to-fail situation again,” he muses.

All talk no teeth is Rosenblum’s basic criticism of Dodd-Frank, as its “pretense of toughness on TBTF” is not matched by giving watchdogs “the foresight and the backbone to end TBTF by closing and liquidating a large financial institution,” in a fashion consistent with the U.S. bankruptcy code.

“For all its bluster, Dodd-Frank leaves TBTF entrenched,” he continues, and the survivors of the 2008 crisis don’t look a whole lot different more than three years later.

The ultimate solution, advocated by the Dallas Fed, is to remove the “too big” portion of the term from the equation, and break up America’s biggest banks. Rosenblum acknowledges the heavy toll that requires – “Taking apart the big banks isn’t costless. But it is the least costly alternative – but warns that “concentration in the financial sector is anything but natural and warns of letting an improving economy and calmer markets allow a sense of complacency to take root:

Human weakness will cause occasional market disruptions. Big banks backed by government turn these manageable episodes into catastrophes. Greater stability in the financial sector begins when TBTF ends and the assumption of government rescue is driven from the marketplace.

…

The ultimate destination – an economy relatively free from financial crises – won’t be reached until we have the fortitude to break up the giant banks.

Too Big Too Fail banks have been among the market's best performers year-to-date, none more so than BofA, which was down 2% Thursday but still up more than 73% in 2012. Citigroup fell 2.4%, JPMorgan 0.7% and Wells Fargo 1.5%, while Goldman Sachs and Morgan Stanley lost 1.1% and 1.8%, respectively, alongside general market declines.